After an indecisive election result back in September, Angela Merkel entered into exploratory talks for a three way coalition government with the liberal Free Democrats (FDP) and the environmentalist Greens. However, these talks broke down over the weekend as the Free Democrats walked out, claiming there was “no common vision for modernisation of the country or common basis of trust” between the parties.

The Euro dropped against a range of currencies, including the Pound and the US Dollar, following the news.

What are the options now?

If the three-way coalition is no longer possible, there are three main options available to Angela Merkel:

• Resume the Grand Coalition: Some have suggested that a new coalition could be formed with the second largest party, the Social Democrats (SPD), her coalition partners before the election. However, this was ruled out by the SPD’s leader Martin Schulz shortly after the election results were announced, and these objections were re-iterated on Monday. After suffering their worst election result since 1949, the SPD have suggested that they now need to distance themselves from the previous coalition in order to rebuild their party.

• Form a Minority Government: Merkel could continue negotiations with the Green party, which might enable her to form a minority government. This would leave her 42 seats short of a majority in the Bundestag, which currently has 709 seats. However, this option has not been attempted at a federal level and it would make it very difficult for her to pass laws.

• Back to the Ballot Box: If a government cannot be formed, fresh elections could be held. These would need to be called by Germany’s President, Frank-Walter Steinmeier, in a process that could take months. Merkel’s party and the President are keen to avoid this option if possible, as it is expected that this would benefit the far-right Alternative for Germany (AfD).

Merkel has indicated that she does not plan to be chancellor of a minority government, and said that “My point of view is that new elections would be the better path.” She has also suggested that she hopes the SPD will reconsider their position.

Whatever option is pursued, it appears that it could take some time before a government can be formed in Germany and that some difficult decisions may need to made along the way. Questions might also be raised about Angela Merkel’s future if she is not able to reach a solution.

What does this mean for the Euro?

As the news broke, the Euro came under pressure against the Pound and the US Dollar, although it later stabilised. For now, it appears the markets remain confident in the German economy. However, if another election becomes more likely or if Merkel’s position comes into question, this has the potential to create some volatility.

At the same time, there were suggestions that Theresa May had secured an agreement with her senior ministers to increase the amount she is willing to pay as part of the Brexit “divorce bill”. This created some optimism that this could help to break the current negotiation deadlock, causing the Pound to extend its gains against the Euro. The long term direction for Sterling remains uncertain though, as it is unclear whether the EU will accept the new offer.

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